U.S. accounting standards require companies to recognize expense based on the fair value of the stock-based compensation awards issued to employees; most commonly these are stock options and restricted stock units. Some know this accounting standard as Financial Accounting Standard (FAS) 123R, now referred to as Accounting Standards Codification (ASC) 718.
Most companies adopted this standard in 2006 and concurrently decided to exclude stock-based compensation expense from their financial statements when reporting their results to investors in earnings releases. Why? The most common reasons were that the charges were noncash in nature and that they believed excluding these amounts made their financial statements more comparable period-over-period and more comparable with other companies’ financial statements.
Now Facebook’s situation is calling this tradition into question.
In an article released Sept. 22, Barron’s questions the value of Facebook stock and criticizes the company for excluding stock-based compensation expense from its adjusted earnings. “This dubious approach to calculating profits is based on the idea that only cash expenses matter,” writes Andrew Bary. “That’s a fiction, pure and simple.” (Read “Still Too Pricey” online.)
Facebook, however, believes that by excluding these costs they are providing meaningful supplemental information to investors. In Facebook’s earnings release for the second quarter of 2012, it’s explained that “varying available valuation methodologies, subjective assumptions and the variety of award types that companies can use” can cause incomparability between Facebook and the competition. The earnings release also references the $1 billion expense, which was technically granted and earned over several years, that Facebook recognized in their first quarter as a public company.
Ironically, the top two reasons the Financial Accounting Standards Board (FASB) issued its fair-value accounting guidance were 1) to address concerns from financial statements users, including institutional and individual investors, regarding the faithful representation of compensation expense; and 2) to improve the comparability of reported financial information.
Here’s the big question: is stock-based compensation expense really a meaningful measure of a company’s operating performance? Both Google and Apple would join Facebook in saying it isn’t. I can see arguments for both sides, but it’s not about what I believe: it’s up to investors to draw their own conclusions. While companies like Facebook (technology companies especially) generally exclude stock-based compensation expense from their reported non-GAAP earnings, they are also required to provide disclosures, including the amounts excluded and the basis for excluding the charges. So, if you believe that Facebook shouldn’t have excluded $1.1 billion of stock-based compensation expense from its reported $1.9 billion of total operating expenses for the second quarter of 2012, or the $2.2 billion of unrecognized stock-based compensation expense as of June 30, 2012 that it expects to recognize over the next two years, then add it back in. It’s a calculation, not a conspiracy.
For another look at stock compensation, see RoseRyan guru Stephen Ambler’s “Stock compensation rules mask true operating performance.”
